1031 Exchange: An Advanced Real Estate Strategy

The vast majority of commercial real estate buyers don't make use of the wealth-building advantages of the tax-deferred 1031-Exchange. Once a property sale goal is realized, many owners sell the property, pay taxes, and then purchase other real estate, without using a 1031-Exchange. 1031 Exchanges are useful in a wide variety of circumstances. They provide excellent opportunities for resourceful buyers to create transactions which would not be possible through a sale-purchase format.

"Like-Kind" Property Exchanges

The Internal Revenue Code Section 1031 (a) (1) says, "no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment."
What does the code really mean? Property that is held for investment can be exchanged for any other property that is being held for investment and the owner will be allowed to defer paying capital gains taxes.

What are some properties held for productive use in a trade or business or for investment? The list includes apartments, single-family rentals, office buildings, retail centers, warehouses, farms, hotels, and raw land, to name a few.

The way the code reads, any combination of these properties can be exchanged. For example that means an apartment can be exchanged for an office building, a warehouse exchanged for a retail center, or raw land exchanged for a single-family rental.

In an exchange of real property for real property, the fact that any real property is improved or unimproved is immaterial, because that fact relates only to the grade or quality of the investment property and not to its kind or class.

Maximizing Return

Sophisticated real estate owners know that leverage can maximize wealth. A 20% down payment can result in a 50% investment return with the right amount of debt and financial leverage. Tax deferment is also a type of leverage. Just as you use debt financing to leverage a purchase, you can use tax savings to acquire even greater wealth. With the successful use of tax-deferred 1031-Exchanges, a savings of 20% to 40% of capital gains tax and depreciation recapture on the sale of their prior property can now be retained to acquire larger properties. A buyer can accelerate his investment horizon by many years by carefully developing an strategy utilizing these exchanges.

Growing Equity Without Capital Gains

The overriding advantage of a 1031 Exchange lies in the ability to move equity from property to property without having to pay the capital gains taxes. Exchangers can create an entire purchase program using the wide variety of benefits available, and a buyer can move successively from one 1031 Exchange to another any number of times. You don't need to wait until a property is under contract to get the process started. Please contact us to discuss your specific requirements.

Why a 1031 Exchange?

Exchanging or "trading up" under Section 1031 and the 2004 IRS DST guidelines allows owners to re-invest in larger commercial properties while also deferring capital gains taxes. The most common reasons for exercising a 1031-Exchange are:

Exchanging from commercial property which can't be readily refinanced, such as land, to improved property which will support a new loan. This makes it possible to obtain cash, and trading from non-productive land to improved property can also create improved cash flow.

Exchanging from a high-appreciation property (such as a rental house or apartment) to a high-cash-flow property (such as a retail center), or vice-versa, depending on investment objectives.

Exchanging from a property with high debt service payments into a property with lower payments or lower interest.

Exchanging to change your lifestyle. For example, exchanging into a property requiring no management for a property owner wanting to travel or retire.

Exchanging from several smaller properties to a single larger building to consolidate ownership benefits.

Exchanging from a larger building to several smaller properties to improve liquidity or to diversify ownership among several persons.

Exchanging to convert the nature of the investment. For example, exchanging from a rental house or apartment to a small medical building for the doctor who wishes to practice in a building he owns.

Leases of 30 years or more may be traded for real estate. Sale lease backs have been ruled to be exchanges, if handled properly.

Exchanging for a property that will be easier to sell.

The IRS and 1031 Exchanges

The delayed exchange procedure was brought to the attention of the real estate community when a property owner by the name of T.J. Starker and his family attempted to trade timberland to the Crown Zellerbach Corporation in exchange for a promise to deliver suitable trade properties to the Starkers in the future.

The IRS challenged this transaction and after a series of tax court trials, the 9th Circuit Court of Appeals ruled in favor of Mr. Starker. Regulations issued in 1991 validated the use of the 1031 Exchange on a national basis.

The 1031 Exchange is an entirely legal and defensible way to defer capital gains taxes, and has been used thousands of times over the years.